Breaking

Shinzo Abe’s (Mostly) Sensible Plan for the Bank of Japan

Jan. 4 (Bloomberg) -- Japan’s new prime minister, Shinzo
Abe, has promised to force the Bank of Japan to change its
monetary policy, and he seems likely to get his way. Though
Abe’s approach isn’t risk-free, he is mostly right.

Critics see Abe’s plan as a dangerous assault on the BOJ’s
independence. These fears are overblown. The more pressing issue
is Japan’s stagnant economy. Consumer prices have flatlined or
fallen, which has held real interest rates above zero and made
monetary policy too tight. Prices fell by 0.3 percent in 2011,
were unchanged in 2012 and are expected by the International
Monetary Fund to fall again in 2013.

Digging out of deflation isn’t easy, but the U.S. Federal
Reserve, the Bank of England and other central banks have shown
that unorthodox measures can work even when interest rates have
been cut to nothing.

In principle, the Bank of Japan agrees. It has done some
quantitative easing through its asset-purchase program and has
kept interest rates near zero, but it has been timid in two main
ways.

First, it bought mostly short-term securities. Because
these are close substitutes for cash, issuing money to acquire
them does little to ease monetary conditions. QE on a bigger
scale and directed at longer-term securities, in the style of
the Fed and the Bank of England, would be more effective.

Talking Down

Second, the BOJ has undermined its own modest efforts by
talking them down. In monetary policy, “forward guidance”
about the central bank’s intentions is a powerful instrument in
its own right. The Fed has put increasing stress on this, for
instance by promising to keep monetary conditions loose even
after growth picks up. The BOJ has usually done the opposite,
which is tantamount to telling markets its efforts will fall
short.

Last October, in an unusual joint statement with the
government, the BOJ said it thought price stability in the
medium term was consistent with inflation of 2 percent or less.
Yet at the same time it affirmed an inflation goal of 1 percent
“for the time being” -- then semi-retracted even this by
announcing that easing would continue until the 1 percent goal
was “in sight,” not until it was achieved. This excess of
caution is self-defeating.

Under mounting pressure from Abe and others, the BOJ
announced new asset purchases in December and said it would
review its medium-term price-stability goal at its next policy
meeting later this month. Abe is calling for a 2 percent
inflation target and threatening legislation. A new governor is
due to be appointed in April in any event. One way or another, a
long-overdue loosening of policy and a stronger commitment to
see the new policy through look likely.

What about the risk that attacking the BOJ’s independence
in this way will shatter confidence in Japan’s financial system
-- maybe causing a collapse in the yen and a spike in long-term
interest rates, enough to push the economy into an even deeper
hole?

Abe’s critics have a point. With enormous public debts,
Japan is already fiscally stretched, and Abe is promising a big
new stimulus program as well as demanding easier monetary
policy. If the BOJ were simply put at the government’s command
and instructed to finance ever-bigger deficits, the critics’
fears could come true.

Abe invoked this possibility when he called for the central
bank to buy construction bonds in support of public-works
spending. He has since withdrawn that suggestion, which is wise.
Outright monetization of government spending at the finance
ministry’s direction would reduce the central bank to a printing
press -- a reckless notion, to put it mildly.

Yet this doesn’t have to happen. A democratically
sanctioned inflation target of 2 percent to 3 percent, together
with operational independence and proper accountability for the
central bank in achieving that goal, is the right approach,
tried and tested elsewhere.

In aiming merely to get inflation of 1 percent “in
sight,” the BOJ settled on a bad target and failed to achieve
even that. The government is right to complain, to press for a
better inflation target and to hold the BOJ accountable for
hitting it. So long as it draws the line there, it will not
compromise vital principles of prudent central banking, but
uphold them.